Examkin

Question

Difficulty: MediumForeign Exchange Market, Systems, and Exchange Rate Determination

When a country experiences a major increase in global demand for its agricultural exports, how does this economic shift impact the value of its currency in a flexible exchange rate market?

  1. The demand for the domestic currency shifts to the right, leading to an appreciation of the domestic currency.Answer
  2. B
    The quantity demanded of the domestic currency decreases along the curve, resulting in an official devaluation.
  3. C
    The supply of the domestic currency shifts to the right, automatically increasing central bank foreign reserves.
  4. D
    The market price mechanism fails, requiring the central bank to set a maximum price ceiling on the currency.

Answer

The demand for the domestic currency shifts to the right, leading to an appreciation of the domestic currency.
Under a flexible exchange rate system, currency value is determined by supply and demand. An increase in demand for a country's exports increases the demand by foreign buyers for that country's currency. This shifts the demand curve for the currency to the right, driving up its price (appreciation).

Step-by-Step Solution

1
Identify the cause of exchange rate changes
Higher export demand means foreign importers must purchase more of the exporting nation's local currency to pay for goods.
International trade transactions require currency conversion in foreign exchange markets.
2
Determine the curve shift in the forex market
The demand curve for the domestic currency shifts to the right (D0→D1D_0 \rightarrow D_1).
An increase in export demand is a non-price determinant that shifts the demand curve outward.
3
Analyze the impact on exchange rate equilibrium
The market equilibrium price (exchange rate) of the domestic currency rises, which is termed appreciation.
Under a flexible exchange rate system, market forces of supply and demand freely adjust the exchange rate.

Key Concept

Exchange Rate Determination in a Floating System
Rate this question

Topics

Foreign Exchange Market, Systems, and Exchange Rate Determination

More questions from this topic